Lawmakers want traders to set aside reserves for derivatives

House Financial Services Committee Chairman Rep. Barney Frank, D-Mass.
House Financial Services Committee Chairman Rep. Barney Frank, D-Mass. Manuel Balce Ceneta / AP

WASHINGTON — The chairmen of two congressional committees on Thursday unveiled guiding principles for complex legislation to begin regulating the so-called dark markets that played a major role in last year's near-meltdown in global finance.

Their legislation would create rules and reporting requirements for an opaque area of finance called over-the-counter derivatives or swaps.

These are trillions of dollars in bets made in the form of private contracts between two parties, and not on any regulated exchange. These bets are placed on everything from movements in the value of currencies to the price of oil to the possibility of debt defaults.

Many companies use swaps to hedge against risks. However, the lack of any meaningful transparency in these dark markets or requirements to hold money in reserve to cover these bets, led to September's collapse of insurer American International Group, which was rescued by the Federal Reserve.

Billions in taxpayer dollars were subsequently spent to settle AIG's swaps in an attempt to calm the panic. The lack of transparency in this enormous market was a big factor in the credit crisis, because banks were afraid to lend, as they were unsure of who was exposed to how many bets.

Reps. Barney Frank, D-Mass., the chairman of the House Financial Services Committee, and Collin Peterson, D-Minn., the chairman of the House Agriculture Committee, told reporters Thursday that they seek to reverse an era of virtually no regulation.

"Barney and I want to err on the side of too much regulation rather than too little, given what we've been through," Peterson said.

Their two panels will take up the legislation in September.

Their legislation would mandate that the bets be settled on an approved clearinghouse. Traders would be encouraged to do business on an exchange or electronic-trading platform, which would bring these products in line with most other financial instruments.

Issuers of complex swaps would have to set aside more cash in reserve and certain percentages per bet — called capital and margin requirements — to ensure that they remain solvent if credit gets tight, and to ensure that they can pay off losing bets.

Lawmakers have talked to regulators in London, Canada and Europe in hopes of creating regulations that would apply at home or abroad.

Here are some answers to questions about what's being fixed.

Q: How would this legislation address rampant speculation?

A: In the area of credit-default swaps, which are like insurance policies against the possibility of a default or rating downgrade on a corporate bond, the buyer of a swap would have to own the referenced bond or security.

Right now, many buyers of swaps have no underlying stake in a company but essentially bet against them through what are termed "naked swaps." Some large U.S. corporations last year found it difficult to renegotiate debt because holders of swaps wouldn't play ball, hoping for a big payday if they could hasten a debt default.

Q: How would it bring more transparency?

A: The bill seeks to enhance oversight and reporting. Anyone taking a short position in credit-default swaps, betting in favor of a default, would have to share that confidentially with a regulator. This would apply to the big Wall Street firms that are the swap dealers, investment advisers who manage more than $100 million in assets and other players considered "major market participants."

Q: Would the legislation do anything about oil speculators?

A: Yes. Requirements for much more reporting on swaps would give regulators a much better sense of how much betting is taking place in dark markets on shifts in the price of oil. Currently, big Wall Street companies enter bets with private investors on what will happen to oil prices, and they hedge these bets in the regulated, open futures market where contracts for future delivery of oil are traded. They also enjoy special exceptions that exempt them from exchange limits on how many contracts they can own.

Armed with this information, regulators would finally get a complete look at the across-the-board investment stakes that big Wall Street firms such as Goldman Sachs and Morgan Stanley have in oil contracts. If their aggregate investment in oil and natural gas is as large as many analysts think, regulators would be empowered to limit the number of contracts these giants can hold_ called position limits.

Q: Why does that matter to oil prices?

A: Some analysts think that big financial companies push up the price of oil through large combined holdings in regulated, dark and overseas markets. These companies also invest with or on behalf of large pension funds and endowments that are seeking to diversify their assets and invest some in an index of commodities such as oil, natural gas and wheat. This, too, may be driving up prices.

"Basically, in my opinion they are gambling . . . they might as well go to Las Vegas," Peterson said.

Q: Why not just limit how much speculation can take place?

A: Rather than try to impose a fixed number on speculative investment, lawmakers hope the limits imposed on big traders will have the same effect, discouraging excessive speculation while still allowing for healthy speculation.


Description of principles

Administration May proposal on derivatives


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